Maybe Not So Big a Mystery

In his Washington Post column this morning Robert Samuelson muses about the mystery of low inflation:

From 2010 to 2018, the CPI has increased only about 2 percent annually. In turn, the collapse of inflation has transformed political debate. We have gone from worrying about “stagflation” — the coexistence of high inflation and high unemployment — to arguing about economic growth and inequality. On the whole, this is a better place to be.

Recall the “misery index.” It combines the unemployment rate and inflation. In 1980, the index was 19.6 percent (7.1 percent unemployment rate and 12.5 percent inflation). In 2018, it was 5.8 percent (3.9 percent unemployment and 1.9 percent inflation). There won’t be much anti-inflation rhetoric in the 2020 campaign. Indeed, low inflation is one reason the current economic expansion is the longest in U.S. history. Despite the running feud between President Trump and the Federal Reserve, there has been no sharp increase in interest rates to dampen the recovery.

But there is one gaping hole in this otherwise happy story: We don’t know what has caused inflation to drop so low and to stay there. It’s a “puzzle,” as economist Janet Yellen, former chair of the Fed, recently put it at a Brookings Institution conference on inflation. The explanation matters. If we don’t fully understand low inflation, we may misinterpret its consequences.

The inflation mystery poses a simple question: Why haven’t wage gains increased faster as the economy has approached “full employment,” which is crudely put between 4 percent and 5 percent? Expressed technically, the question becomes: Why isn’t the Phillips Curve working? That’s economist A.W. Phillips, who argued in the 1950s that, as unemployment fell, wage gains would rise. Firms would have to pay more to attract workers. Some wage gains would feed into higher prices, a.k.a. inflation.

I don’t think it’s that big a mystery. Mr. Samuelson points to globalization, monetary policy, and a misinterpretation of the labor force as potential explanations and I think that’s partly right. My explanation would include four factors:

1. An enormous proportion of the economy is either grey or black and not included in the official statistics. When you have an illegal population as large as we do—officially about 14% of the population but actually possibly much higher—the statistics are just wrong.
2. For the last couple of decades China has been exporting goods and deflation and importing employment and inflation. There’s lots of inflation but in a globalized economy you can’t see it if you only look at one country.
3. The CPI is broken. It represents the economy of 50 years ago not the economy of today. The problem may well be in the weighting. In particular now that health care is a sixth of the economy and education (public and private) may be as much as 10% of the economy is that reflected in the CPI? Keep in mind that not only health care and education but military spending, police and fire, and other components of government spending including public pensions, particularly at the state and local level, are consumption and that spending is increasing at a ferocious rate. There may be lots of inflation; it just isn’t reflected in an obsolete CPI.
4. Monetary policy is working. It’s creating enormous inflation in the prices of equities. Evidence for that are the price/earnings ratios, unlike anything seen in the past. That’s also reflected in sharp increases in things closely tied to the prices of equities, e.g. executive compensation.